A key portion of the Treasury yield curve has largely returned to flat, more than two years after it inverted and triggered a blaring recession signal.
The spread between the 10-year and 2-year Treasury bond yields, which has been negative since July 2022, briefly reached zero earlier this month after a weaker-than-expected jobs report boosted the expectations for multiple Fed rate cuts before the end of 2024. The spread settled at negative 5 basis points Aug. 8.
While the inversion has long been viewed as an indicator of a looming recession, recent market turmoil does not mean a recession is any more likely than it was a month ago. Other portions of the curve remain far from balance and the direction of government bond yields, as well as the likelihood of a near-term recession, depends on the Federal Reserve's monetary policy plans and the state of the economy that will surely drive them, according to fixed income strategists.
"The curve is dictated by the Fed and the Fed is dictated by the economy," said Timothy High, a senior rates strategist at BNP Paribas. "The more we steepen, the more that the Fed has to cut, the more that the Fed cuts is the response to a weaker economy."
The spread between the 10-year and 2-year Treasury yields, which grew as large as negative 108 bps in July 2023, has been inverted for the longest stretch in history. Its recent steepening has increased the odds of a recession in the near term.
"When the curve inverts, it's a good recession signal, but it's not a good indicator of the timing of that recession," said High. "There's really no good way to say what the lag is from inversion to recession, but I think the key is when the curve dis-inverts."
While the spread between the 10-year and 2-year yields is now near zero, the spread between the 10-year and 3-month yields, one some market economists believe may be a more effective recession indicator, remains at about negative 140 bps.
A positive slope
The spread between the 10-year and 3-month yields remains far more inverted due to the 3-month yield's proximity to the benchmark federal funds rate, said Padhraic Garvey, head of global rates and debt strategy at ING. The 3-month yield cannot move lower than a fair value estimate for the rate set by the Fed over the next few months, but the 2-year rate works more of an average over the coming two years, when the central bank is expected to cut its benchmark rate considerably from its current level near 20-year highs.
"Assuming we continue on the build for a rate cut from the September meeting, and indeed for a sequence of cuts thereafter, the 2- and 10-year curve should swing into a positive slope," said Garvey. "The risk-off theme [caused by the recent stock market selloff] accelerated some of that process, but history shows that material steepening of the curve is typically reserved for the period where the Fed is actually cutting rates, and that's all ahead of us."
The steepening of the 10- and 2-year curve out of inversion is a "premature wishful forecast" for as much as 125 bps worth of Fed rate cuts before the end of this year, said Arnim Holzer, global macro strategist at Easterly EAB Risk Solutions. That many cuts would only happen in response to a severe recession that has yet to be reflected in any economic data.
"At times like these the differences can be extreme and show where narratives differ," said Holzer. "The 10-year-2-year curve is assuming a dovish program [from the Fed] while the 10-year-3-month remains more skeptical."
The curve will likely further steepen as the Fed nears cutting interest rates, now expected to begin in September, but the direction will hinge on the health of the domestic economy, particularly the relative strength of the labor market.
"The pace of cuts will be key for curve steepening, with the curve steepening further as the market pencils in additional cuts," said Gennadiy Goldberg, head of US rates strategy at TD Securities.
The recent stock market turmoil and increased expectations for multiple rate cuts this year caused the 10-year Treasury yield to plunge below 4% for the first time since February, as demand for the safety of government bonds climbed.
Yields on 10-year Treasury yields may fall to 3.4% by the end of 2024 and 3% by the end of 2025, which would be the lowest level since August 2022, Goldberg said.
Weaker than expected economic data could push the 10-year yield lower, though stronger economic data could keep the yield above 4% as expectations for rate cuts are reduced, said Steve Wyett, chief investment strategist at BOK Financial.
"We are expecting the Fed to begin re-calibrating policy and lowering rates but this will not be a traditional 'easing' cycle where the Fed is trying to spur economic activity," Wyett said. "Spurring additional activity is what they do not want to do. Inflation is not back to target and higher economic activity would, in their mind, slow progress to getting there."